How 50 bln euros might save the euro

The break-up of the euro would be a multi-trillion euro catastrophe. An interest subsidy costing around 50 billion euros over seven years could help save it.

The immediate problem is that Spain’s and Italy’s borrowing costs – 6.3 percent and 5.8 percent respectively for 10-year money – have reached a level where investors are losing confidence in the sustainability of the countries’ finances. A vicious spiral – involving capital flight, lack of investment and recession – is under way.

Ideally, this week’s euro summit would come up with a solution. The snag is that most of the popular ideas for cutting these countries’ borrowing costs have been blocked by Germany, the European Central Bank or both.

Take euro bonds, under which euro zone countries would collectively guarantee each others’ debts. They would allow weak countries to borrow more cheaply. But Germany won’t stand behind other countries’ borrowings unless they agree to a tight fiscal and political union which prevents them racking up excess debts in future. Such a loss of sovereignty France, for one, will find hard to swallow.

Or look at pleas for the ECB to buy Italian and Spanish government bonds in the market. That too would cut their borrowing costs – for a while. But when the bond-buying ends, the yields would just jump up again. Private creditors would merely use the opportunity to offload their bonds onto the public sector. The ECB has already spent 220 billion euros buying sovereign debt with no lasting impact, and is reluctant to do more.

Italy’s idea that the euro zone’s bailout funds should buy bonds in the market has the same drawbacks. What’s more, the bailout funds only have 500 billion euros left. If they use their firepower to bail out private creditors, they will not have enough to fund governments. Giving the bailout funds banking licences and allowing them to borrow from the ECB would solve that problem. Unfortunately, both Germany and the ECB are against the idea.

But what about a direct interest subsidy? Core countries – such as Germany and France – could pay into a pool an amount that depended on how much their cost of funding was below the euro zone’s average. Peripheral countries  such as Italy and Spain – would then take a sum out of the pool depending on how much their cost of funding was above the average.

The idea recently surfaced in an article by Ivo Arnold, programme director of the Erasmus School of Economics in Rotterdam. It has also been touted by Pablo Diaz de Rabago, economics professor at the IE Business School in Madrid. But it has not yet had much oxygen.

Under such a scheme, the final cost of funds paid by all countries could be equalised or just narrowed. The key questions are: would it work, would it be politically acceptable and is it legal?

First, look at workability. An interest subsidy would help the peripheral countries in two ways. They would benefit from cash payments from the core. But the yield they pay on their own bonds would also drop as worries about the sustainability of their finances eased.

The yields on core bonds, by contrast, would rise. Investors would be worried that Germany and others were shouldering part of the burden of bailing out their neighbours. What’s more, some of money that has rushed into German bonds in recent years would flood out. But, in a sense, this would just be giving back to the periphery a windfall Berlin has enjoyed as investors have panicked over the possibility of a euro collapse.

My colleague Neil Unmack and I have crunched the numbers. Suppose the yield on Spanish and Italian bonds fell by one percentage point as a result of the scheme, and that the yield on the bonds of core countries rose by 50 basis points.

Also assume that core countries were willing to make up half the remaining difference between their interest rates and those in the periphery. That would limit the scale of the subsidy while maintaining pressure on peripheral countries to reform. In this scenario, Spain’s cost of borrowing for 10 years would drop to 4.4 percent, while Italy’s would drop to 4.1 percent – no longer worrying levels.

Now look at political acceptability. The interest subsidy would start off being cheap. On the above assumptions, the first year cost would be only 1.9 billion euros, about 60 percent provided by Germany. Each year, of course, the cost would mount, as countries added new debt to the scheme. But the cumulative cost over the first seven years would still be a manageable 53 billion euros.

The core wouldn’t have to guarantee the periphery’s debt. And subsidies could be provided one year at a time. So if a country didn’t keep up with its reform programme, it could be kicked off the scheme. What’s more, if markets settled down, the operation could be wound down.

Such limitations mean the scheme would be unlikely to fall foul of the German Constitution or the no bailout clause in the EU treaty. Of course, investors may not be convinced that the safety net is strong enough. So it wouldn’t remove the need for Europe’s leaders to come up with a credible long-term vision as well as continue with their reforms. But interest subsidies are still a reasonably cheap and practical answer to the zone’s most pressing problem.

Could have some carrots and sticks built in to comply with country fiscal/structural reform targets (as well as some caps and floors on the level of the interest rates in the periphery which would be used to calculate the subsidy and/or maybe a $ dollar limit on the maximum subsidy which would help it get over German constitutional Court issues).

Could even be funded out of a financial transaction tax pool as an alternative.

Don’t think it would be possible. You are still subsidizing the PIIGS. That does not stop them from borrowing more. The more they borrow the more interest payments they will need? The strong countries would still be at risk because they need to put up funds to pay out. Also, how do you determine who will pay into the fund. Who is “strong” enough to contribute? What is the cut off? Would you ask the PIIGS to contribute into it as well? (meaning they need to borrow even more to put in their bits)

It is in a sense, moral hazard into a black hole where contributors will get nothing back.

This is perhaps the best muddle-through strategy that I have heard of, so the Euro heads of state will probably settle on it at some point. However, I think that your guess about yields coming down by 100 bp from current levels and then staying there is overly optimistic. If so, that boosts the cost up a bit.

Your calculations are based on a 1% cut in rates but more is required if their yields are to be sustainable. Spain would likely need 2-3% for example. Additionally, bond yields are not the main problem. The main problem is that these countries rely on borrowing money to grow, although at the moment they are actually in recession. If their yields were lowered, they would have less incentive to make hard decisions.

Interesting that merely taking care of the interest liability may seem to take care of investors’ concerns. Well I suppose no Government anywhere will ever repay capital, so this may well be a starter. However, those of us with memories that go back to late 80’s will recall the innovative Brady Bonds. South America by and large was then in as much of a mess as is Europe today. If the implication (that no one is suggesting a similar solution for Europe) is that there is no one around who could act as guarantor, then there is simply no solution other than making the European voters pay heavily for many years ahead for the stupidity of those Europhiles who put the whole thing together in the first place.

This seems like a cheaper and more flexible alternative, but it ignores the problem at the foundation of the Euro. Sure, interest subsidies could push off the day of reckoning, but what do we mean when we say “reform”?

The Euro is an equal currency for unequal economies. The problem is that the Euro northern core has a perpetual trade surplus with the Euro periphery, which means perpetual unidirectional cash flow. It’s not sustainable. Can Greece (or Portugal, or…) become an industrial powerhouse to compete with Germany before the subsidy money runs out? I don’t think so.

It does not really matter what solution they come up with. All solutions in one way or another demand Germany to guaranty any credit or loans or eurobonds or what ever you call it. Germany would have to be the bank of Europe, issuing bonds and loans to the other that they cannot pay. In next turn Germany would be so debt ridden that they collapse.
There is no way that Merkel or any German would do such a thing and still be sane. They don’t want to drown themselves with debt while others are using those borrowed money.

How come that you Journalists do not understand such things.

The best thing for Germany, would be to leave the Euro behind and take the loss and start grow again. And Germany would not grow into a possibly enemy of the other European countries. They have learnt that lesson and the population of the nation is to old. There is not enough youngsters to do the fighting, thanks to abortion.

the issue is not the interest. the more important problem is the structural deficit in the budget which cannot be resolved by simply injecting fresh money or subsidizing interst. one key is to change the goverment policy in the relevant countries, but also to change the european policy. the eu-countries need to align their social- and tax-policies and have to adopt a cross-boarder fiscal policy.

I don’t see why Germany or any other “core” country would agree to paying higher interest rates so that other prodigal countries could have lower interest rates. I don’t see this as any different than the basic concept of Eurobonds.

When all the fun and games are over, the grim reaper of Darwinian Capitalism hovers ready to apply the ultimate sanction on the folly of pandering politicians and their greedy minions. Wow, that was a lot of fun to say. Too bad it is the truth.